Why the Bank of England MPC was right to sit on its hands today

The Bank of England has decided not to start hiking interest rates, despite soaring inflation. And a good thing too, given our weedy growth figures.

by James Taylor

Published: 10 Feb 2011

Last Updated: 19 Aug 2013

As expected, the Bank of England's Monetary Policy Committee voted not to raise interest rates today - so we're still at the record low of 0.5%. With inflation at 3.7%, almost double the Bank's 2% target, and more positive economic news starting to emerge (most recently on manufacturing and retail sales), some think it's time to start increasing the base rate from its current record low level of 0.5% - including two members of the nine-person MPC, last time out. But the Bank has stuck to its guns - and according to Fathom Consulting (home of MT's One-Armed Economist blogger Erik Britton) it's a good thing too, because any rate rise could kill the recovery stone dead...

At its quarterly Monetary Policy Forum yesterday, a precursor to the Bank's MPC meeting, Fathom's argument was broadly in line with that of Governor Mervyn King: that the MPC should be worrying about inflation in the medium-term, not the short-term. So although CPI is already so far above target, and may go even higher in January (and possibly higher still in February, after the sales end), Fathom thinks that's no reason to cut now - because given the current state of the UK economy, it doesn't see any conceivable way that inflation can keep climbing over the next year or two.

Why's that? Wages, for one thing; King suggested last week that take-home pay has actually shrunk in the last five years for the first time since the 1920s, and Fathom reckons that even if you extend this to all disposable income (including dividends etc), growth is currently at its weakest since the time of post-war rationing. Then there's unemployment; Fathom thinks this is actually worse than the labour force surveys suggest, because they incorporate lots of 'self-employed' people who might not be working at all. And if that's not gloomy enough for you, try this: according to its 'misery index', we Brits are now more miserable than at any time for the last 25 years. 'This is not an environment where we should be worrying about medium-term inflation,' Britton said, dryly.

So what's the risk involved with putting up rates? Well, the housing market - a huge part of our national wealth - is perhaps the most obvious example. Some estimates suggest that prices have another 7% or so to fall, and may not get back up to current levels for 6 years (and even then will be 18% below their 2007 peak). Mortgage default rates have remained surprisingly low, but Fathom thinks this is largely to do with ultra-low rates. But mortgage spreads (the difference between borrowing rates and the base rate) are already widening. So pushing up interest rates now could have a disastrous effect on households already struggling to make ends meet, particularly as the Government's austerity measures kick in.

(Britton cited the example of Japan, which cut rates too soon during its recovery in 1996, and has never really recovered; he acknowledged that the two cases weren't directly comparable - but joked that if anything, they were better off than us).

Is this gloomy outlook right? Only time will tell - but it's worth mentioning that panel members Dr Deanne Julius and Professor Tim Besley, both former members of the MPC, both took a rather more optimistic view, particularly on jobs (Julius pointed out that the outlook within SMEs looked pretty positive) and the austerity squeeze (the impact of which Julius thinks has been exaggerated). And all agreed that the private sector did provide some hope: if all those big companies sitting on huge cash surpluses start ploughing their money into fixed investment, there's still a chance that the UK economy could bounce back.

Although there was no action today, Julius and Besley both thought a rate rise would happen sooner or later, perhaps in May after the release of the next inflation report. If Fathom's right, even that may be too soon.